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Econintersect: Derivatives contracts have been called the ticking time bomb in the financial world. A derivative can work in many ways, acting like an insurance policy - guaranteeing payment or performance of an underlying contract - in some cases, and functioning as pure speculative vehicle in others. In a financial crisis (such as in 2008), they can create an immediate cascade of events wiping out the financial world.

Follow up:

It has been argued that the $700 trillion global swaps market actually nets out to a small fraction of that in actual risk exposure because various contracts are partially cancelled by counterparty positions - so the nominal total value of $700 trillion does not represent the size of the risk.

But there has been a problem with that argument because a significant portion of the existing derivatives transactions with large banking organizations have contracts permiting counterparties to liquidate, terminate, or accelerate contracts upon the banking organization's failure. Once even a small counterparty position is cancelled, the domino effect cascading from institution to institution can bring the system down.

This was a significant factor in triggering the Great Fnancial Crisis when Lehman failed. Even though Lehman was a very small player in the derivatives market, their one little domino started a chain of counterparty failures that affected trillions of dollars of contracts. Eventually the counterparty interactions were sorted out with most "defects" cancelled. But before that happened the financial world shut down.

This is now been changed. But the question that remains is whether it has a significant impact on ending the too-big-to-fail problem.

WASHINGTON, DC, October 11, 2014 – The International Swaps and Derivatives Association, Inc. (ISDA) today announced that 18 major global banks (G-18) have agreed to sign a new ISDA Resolution Stay Protocol, which has been developed in coordination with the Financial Stability Board to support cross-border resolution and reduce systemic risk. This represents a major step in strengthening systemic stability and reducing the risk that banks are considered ‘too big to fail’.

The Protocol will impose a stay on cross-default and early termination rights within standard ISDA derivatives contracts between G-18 firms in the event one of them is subject to resolution action in its jurisdiction. The stay is intended to give regulators time to facilitate an orderly resolution of a troubled bank.

“This is a major industry initiative to address the too-big-to-fail issue and reduce systemic risk, while also incorporating important creditor safeguards. The ISDA Resolution Stay Protocol has been developed in close coordination with regulators to facilitate cross-border resolution efforts and reduce the risk of a disorderly unwind of derivatives portfolios,” said Scott O’Malia, ISDA Chief Executive.

The Protocol essentially enables adhering counterparties to opt into certain overseas resolution regimes via a change to their derivatives contracts. While many existing national resolution frameworks impose stays on early termination rights following the start of resolution proceedings, these stays might only apply to domestic counterparties trading under domestic law agreements, and so might not capture cross-border trades.

Regulators have committed to develop new regulations in their jurisdictions in 2015 that will promote broader adoption of the stay provisions beyond the G-18 banks. Banks have also committed through the Protocol to expand coverage once such regulations are enacted to include a stay that could be used when a US financial holding company becomes subject to proceedings under the US Bankruptcy Code. Those regulations will be made under the rule-making process in each jurisdiction.

The contractual approach is meant to support current statutory regimes and ensure wider, more consistent application. By adhering to the Protocol, the G-18 banks will extend the coverage of stays to more than 90% of their outstanding derivatives notional, and that proportion will increase as other firms sign the Protocol.

The terms of the Protocol have been agreed in principle, and it is scheduled for implementation in early November. The Protocol will take effect from January 1, 2015, and will govern both new and existing trades between adhering parties.

The Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation welcome the announcement today by the International Swaps and Derivatives Association (ISDA) of the agreement of a new resolution stay protocol.

A significant portion of bilateral, over-the-counter (OTC) derivatives transactions with large banking organizations permit counterparties to liquidate, terminate, or accelerate the contract upon the banking organization's failure. Following the recent financial crisis, global financial regulators have focused on the potential for such contractual rights to disrupt the execution of an orderly resolution of a major global banking firm.

This initiative is an important step toward mitigating the financial stability risks associated with the early termination of bilateral, OTC derivatives contracts triggered by the failure of a global banking firm with significant cross-border derivatives activities. Initially, 18 large banking organizations have agreed to sign onto the protocol. The protocol provides for temporary stays on certain default and early termination rights within standard ISDA derivatives contracts in the event one of the large banking organizations is subject to an insolvency or resolution proceeding in its home jurisdiction.

The resolution stay amendments of the protocol are intended to facilitate an orderly resolution of a major global banking firm and reduce the potential negative impact of the resolution on financial stability by giving the bankruptcy court or resolution authority the ability to prevent early termination of financial contracts of the firm's global subsidiaries. The Federal Reserve and the FDIC are encouraged by this effort and look forward to the continuation of this important work.

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